private equity investing in china...prc listed companies con’t transaction requirements the shares...
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© 2013 Winston & Strawn LLP 2
沈永熙 <Shen yongxi> Senior Partner Major: VC\ PE\ major controversies\ IPO&RTO\ A&R EDU : LL.M at China University of Political Science and Law, LLB at Nankai University, China. Work Experience: 2007-pre Dacheng Law Offices, Senior Partner and Attorney at Law 2010-pre Dacheng Law Offices (New York), Senior Partner 2011-pre Dacheng Wong Alliance LLP, Senior Partner 2007-2011 Dacheng Central Chambers LLP, Senior Partner 1998-2007 Jiade Law Offices, Founder and Attorney at Law 1993-1998 King & Wood, Attorney at Law .
E-mail Address: [email protected]
Tel: 8610-58137321 13910501972
Speaker
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Background for Investment in China
Capital reallocation from developed countries to China mostly via private equity and cross-border mergers and acquisitions
More than 7% growth in China’s GDP annually, but less than the central target of 8%
Political stability, steady domestic and foreign investment Recent SEC fraud investigations, US stock exchange delistings,
securities law class actions and settlements, privatizations of Chinese companies listed in the U.S.
Is China’s role as one of the factories and R&D centres of the world fading?
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Foreign Direct Investment
Capital contributors: Hong Kong, Taiwan, United States
Industrial Sectors: manufacturing, telecom Recent examples
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Early Experience
Lessons from Hong Kong and Taiwan Since 1980, overseas Chinese from HK and Taiwan have
moved their manufacturing base across the border because of cheaper labor then, and availability of land
Operated through contractual or equity joint ventures or subcontracting arrangement
Examples of transactions
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Direct Investment
Between 1990-2012 income of U.S. foreign affiliates in China generates considerable earnings
Foreign capital reallocation to China (securing control value chain across production operations by acquiring strategic Chinese assets and talents) in: Telecom Semi-conductors Healthcare Financial services
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World Trade Organization and CEPA
Officially joined WTO in December 2003: Opened vast opportunities for private equity investments;
retail opportunities under CEPA Especially in the growing sectors Particular interest in capital-intensive industries such as chip
manufacturing and telecom equipment
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Evaluation of Risks
Unreliability of disclosed information and faked financial reporting
Centrally planned economy lacks free competition Lack of predictability and transparency in Chinese
business environment: Inconsistent interpretation and application of laws and
regulations
Chinese Government over-protects local firms Foreign enterprises too enthusiastic
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Funding of PE Investments
Huge returns to early PE investors in Facebook and Chinese game company Shanda Types of private funding: Seed financing Family and friends Angels Incubation funds Strategic investors and venture capital
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Funding of PE Investments
Documents and information required: Executive summary Business description Management team Growing market description Revenue sources Specify proposed investment amount Use of investment proceeds
Advantages, time or path to profitability, etc.
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Funding of PE Investments
Business plan Private placement memorandum to contain:
Business summary and description Description of target market Explanation of revenue sources and timing of revenue
generation Scalability of products and services Capitalization table
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Funding of PE Investments
Financial statements and projections should be reasonable but conservative
Risk factors Description of competition Management profiles Strategic parties’ beneficial ownership table Path to profitability Use of proceeds and projected marketing/operating
costs, cash burn Exit timing/exit format
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Funding of PE Investments
Differences between a Business Plan and PPM: Business plan is primarily a selling tool PPM explains the business and protects the founders by
highlighting risk factors PPM contains securities law disclaimers More detailed projections When to use which document
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PE Due Diligence
Confidentiality Agreement Protects confidential nature of target's information Sets rules for due diligence
Who may receive the confidential information, e.g., only employees/agents with a "need to know" and who have agreed to be bound by the confidentiality agreement
Limits investor's contact with target, avoids business disruption, employee panic, and customer/vendor defections
Return of confidential information No solicitation or hiring of target's employees
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PE Due Diligence
Letter of Intent/Term Sheet: Memorializes parties' general agreement – helps avoid
misunderstandings or "changes of heart" May reveal irreconcilable disagreements May make transaction cheaper, but could become time-
consuming and the deal may become stalled Often contains target's exclusivity covenant, no shop May contain investor covenant not to solicit employees or
customers of target
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PE Due Diligence
DD Purposes Gather general industry, market, competition, management
information Better understanding of the target, its business,
assets/liabilities Identify risks, potential issues impacting investment cost Guidance for drafting and negotiation of investment
agreement Verify disclosure schedules Identify closing conditions Identify matters for indemnification
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PE Due Diligence
Types of due diligence Legal: contract review, litigation, lien, judgment searches Environmental; accounting/tax Employee benefits; insurance, coverage and claims history Real property, title and surveys; intellectual property: patent,
trademark and copyright searches Foreign Corrupt Practice Act review
Due diligence request list Define target to include all subsidiaries, including predecessors Open-ended, all-encompassing diligence requests vs. more
focused, target-specific diligence requests
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PE Due Diligence – Legal & Compliance
Target’s corporate structure? How long has it been structured? Proper PRC governmental approvals?
Is target’s business subject to any contingent liabilities? Litigation claims; governmental investigations, FCPA issues,
audits or claims for labor and employment; environmental; health & safety; antitrust; securities; criminal investigations
Tax audits or disputes; intellectual property claims (Apple vs. Samsung)
Insurance coverage disputes Shareholder, employee, customer, or supplier disputes
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PE Due Diligence – Legal & Compliance
Is target subject to any change of control payments to management, creditors or any other party?
Is target subject to any contractual restrictions affected by the transaction? Any non-assignability or change of control restrictions in
target's major contracts with customers and suppliers, labor agreements, debt instruments, joint venture agreements, governmental authorizations, retirement plans, non-compete provisions with suppliers, customers, equity holders, or partners, debt incurrence or other structuring limitations in material agreements
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PE Due Diligence – Legal & Compliance
Is target or investor required to gain approvals to enter into transaction? Estimated time needed for approval
Approvals from: Governmental agencies Right of first refusal etc. in shareholders' agreement Shareholders and percentage required
Employee matters Employment agreements Any standard confidentiality, non-compete, or non-compliance
agreements in place?
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PE Investor’s Preferential Rights
Principal Rights of Preferred Stock: Types of investment: common stock, preferred stock,
convertible preferred stock or convertible preferred debt Valuation issues Dividends may not exist or may not be paid currently or
accrue, typically 8% to 12% annually Liquidation preference, the preferred investors will get their
money back first
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PE Investor’s Preferential Rights
Conversion right: Convert at holder’s option into common stock The conversion ratio/price is generally subject to adjustment
if the issuer later issues securities at a lower price, “price anti-dilution protection”
Preferred stock or convertible preferred debt automatically converts into common stock immediately prior to a “qualified” IPO
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PE Investor’s Preferential Rights
Voting Rights Preferred stock or convertible preferred debt generally can
vote with the common stock as one class on an as-converted basis
Preferred stock or convertible preferred debt has special class voting rights with respect to certain matters
Redemption Preferred stock or convertible preferred debt often will be
subject to mandatory redemption by the issuer if the issuer has not been sold or gone public within five years after the financing.
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PE Investor’s Preferential Rights
Other preferential rights: Preemptive right to purchase pro rata portion of new
securities Right of first offer or refusal on sale of founders’ shares Co-sale rights Right to have one or more representatives on the board of
directors Information rights Demand rights Piggyback rights
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PE Legal Issues – Employment Related Issues No employment contract Failure to pay overtime compensation Under-payment of social insurance and other
employee benefits
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PE Legal Issues – Anti-trust Filings
The Ministry of Commerce is responsible for the anti-monopoly review
Anti-monopoly review is required if an acquisition of a domestic enterprise by a foreign investor constitutes “industry concentration”
Industry concentration: The combined global turnover of the acquirer(s) and
acquiree(s) in the previous fiscal year exceeds Rmb10 billion, and the respective turnover in China of at least two parties in the acquisition in the preceding fiscal year exceeds Rmb400 million
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PE Legal Issues – Anti-trust Filings
Industry concentration con’t: The combined turnover of the acquirer(s) and acquiree(s) in
China in the previous year exceeds Rmb2 billion, and the respective turnover in China of at least two parties in the acquisition in the preceding fiscal year exceeds Rmb400 million
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Foreign Investors’ Strategic Investment in PRC Listed Companies
A PRC listed company is not permitted to issue its shares to a foreign individual; however, it can issue shares to a foreign company pursuant to Administrative Rules on Foreign Investors’ Strategic Investment in PRC Public Companies jointly promulgated by several PRC government authorities in 2006
Such share issuance requires approvals from the Ministry of Commerce and China Securities and Regulatory Commission
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Foreign Investors’ Strategic Investment in PRC Listed Companies con’t
Requirements with respect to the foreign strategic investor (“FSI”) FSI is duly established and validly existing with stable
financial performance, good credit, and mature management experience
FSI has established healthy corporate governance and good internal control system
FSI shall own offshore assets of minimum US$100 million or manage offshore assets of minimum US$500 million
FSI has not been subject to any material penalties imposed by any PRC or foreign regulatory agencies
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Foreign Investors’ Strategic Investment in PRC Listed Companies con’t
Transaction requirements The shares issued to the foreign strategic investor shall not
be less than 10% of the PRC public company’s total outstanding shares
There is a three-year lockup period for the shares received from the PRC public company
FSI’s investment in the PRC public company shall comply with the PRC foreign investment catalogue
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Foreign Investors’ Strategic Investment in PRC Listed Companies con’t
Transaction requirements con’t When a PRC public company conducts an acquisition with its
shares as consideration, it is required to enter into a compensation agreement with the acquiree, who is obligated to compensate the PRC public company for any difference between the projected earnings and the actual earnings in the three years after the completion of the acquisition
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PE Legal Issues – PRC Secrecy Law
The Securities and Exchange Commission in December 2012 began administrative proceedings against the China affiliates of the Big Four accounting firms and BDO for refusing to produce audit work papers related to China-based companies under investigation by the SEC for potential accounting fraud against U.S. investors.
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PRC secrecy law con’t
State secrets defined--information and matters relating to national security and interests and that are only permitted to be available to limited number of people within a limited period of time. The following are state secrets if the leakage or disclosure of such may damage Chinese national security and interests in the areas of politics, economy, state defense and foreign affairs: Classified matters involving the key policy decisions on state
affairs Classified matters involving the national defense construction
and armed forces activities
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PRC secrecy law con’t
Classified matters involving the diplomatic and foreign affair activities and classified matters involving the state’s international obligation of secrecy
Classified matters involving the national economic and social development
Classified matters involving science and technology Classified matters involving the activities of maintaining
national security and investigating criminal offences Others classified matters as determined by the state
secret administrative agency
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Restructuring Legal Issues: SAFE Notices
How do the various SAFE notices affect a typical redomicile? Jan 24, 2005 SAFE circular (no. 11) April 8, 2005 SAFE circular (no. 29) October 21, 2005 SAFE circular (no. 75) May 29, 2007 Operating Procedures to clarify no. 75
Approval for overseas investment by Chinese residents
Earlier halting of approval and examination by local SAFE
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Foreign-funded Mergers and Acquisitions of Domestic Enterprises
General Application – applies to domestic companies, enterprises and natural persons (round trip investment)
Article 11 requires Ministry of Commerce examination and approval
Article 29 permits use of equity of listed overseas company as consideration
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Some proposed structures
Creative options Slow Walk structure Variable Interest Entities, VIE structure, questioned in
Shandong Province, China recently Option to purchase employee stock option
Uncertainties and Risks Current issues and creative thinking?
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Other China PE Issues
State assets purchased in an auction? Relevant regulations Applicability of Provisional Regulations on Administration of
Transfer of Enterprise State-Owned Property Rights Effect of Chinese judicial procedures on validity of auctions
not complying with Chinese regulations Other irregularities in the auctions
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Other Issues
Formation of a WOFE using acquired assets: Article 15 of the Pilot Rules on Mergers and Acquisitions of
Domestic Enterprises by Foreign Investors Additional documents needed: Chinese seller’s resolutions
to sell assets, WOFE application letter, WOFE articles of association, translated asset sale agreement, Chinese seller’s articles of association, Chinese seller’s notices to creditors, investor’s documents, and Chinese seller’s plan to lay off its employees, as applicable
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Other Issues
Shareholder loans: Inter-company loans Individual loans Conversion of shareholder loans into registered capital
Land Issues All land belongs to the State Allocated land v. granted land
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Exit Strategies: Mergers and IPOs
Exit by sale or merger: Part of a larger organization Tax considerations Cash vs. stock Stock vs. assets Continuing role of management
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Mergers and IPOs
IPO exit with follow-on offerings: start planning in advance,
decisions involving accounting matters, decisions relating to management retention , selection of professionals
Alternative fund raising: reverse takeover of a listed shell not viable in the foreseeable future for Chinese companies
Universal shelf registration, registered direct, and follow-on offerings
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Mergers and IPOs
Advantages Access to public equity markets will generally enable
companies to secure: Better valuations Less dilution than private equity Avoid interest costs, cash drain, and operating and current
restrictions associated with debt financings
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Mergers and IPOs
Increased options for future financing Currency for acquisitions Enhanced reputation and visibility Enhanced liquidity for investors Incentives for management and employees
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Mergers and IPOs
Disadvantages of public offerings: Loss of confidentiality Increased expenses Considerable management time associated with the IPO
process and periodic disclosures thereafter Dilution of current ownership and potential loss of control Registration process can be lengthy, and Price volatility
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Mergers and IPOs
Other consideration re public offerings: Lock-up arrangements Company's profits must be shared with outside owners Continuous reporting obligations and regulatory
requirements Legal liability, Rule 10b-5 liability for false or misleading
statement of material facts in any offering memorandum or SEC filings
Expenses
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Successful Strategy
China market remains to be tapped With the right people and structure, devise a
winning strategy Accommodate different needs Not an easy task; delicacy of a diplomat and skill of a
mathematician
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Introduction Reasons of PE disputes Features of PE disputes Limitations and problems of resolving PE disputes
by suits or arbitrations overseas Methods to protect the rights and interests of
foreign PE investors in China
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As s new comer in China, PE of considerable distinguishing features and advantages has developed strikingly in China, and causes troubles frequently.
In the case that disputes occurred, foreign investors always resort to litigation and arbitration abroad. However, it seems impossible for them to protect their interests thoroughly.
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I. Fake statements and guarantees of domestic corporations’ founders.
II. De facto controllers of domestic corporations divert, invade and occupy property of corporations.
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III. Connected transactions managed by de facto controllers damage interests of domestic corporations.
IV. De facto controllers of domestic corporations refuse to return de facto control.
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V. PE investors are hardly able to exercise their rights to hear from domestic corporations.
VI. De facto controllers of domestic corporations refuse to carry out the Ratchet terms.
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Four Features of PE Disputes
Lacks of adequate domestic legal basis and judicial precedents.
Diversities and complexities of the model of investments and the frame of stocks.
Laws of several nations are involved in one dispute. The process of solving disputes is complex.
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I. Foreign courts’ judgments, relevant orders of provisional and preservation measures are usually not recognized or enforced in China.
II. Besides, there are circumstances ruled in the Civil Procedure law showing that China can refuse to recognize and enforce certain judgments of foreign courts.
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III. Courts of foreign arbitral authority could not
preserve property and evidence of two parties in China.
IV. Related obligees can not directly take over corporations in China according to relevant orders made by foreign courts
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Case: Danone appointed KMPG as receiver to take over assets of
Wahaha in 2007. Without a permission of a people’s court of China, KMPG just took up activities of taking over. In 2008, the court of the second and final instance judged that KMPG acted against the principle of national judicial sovereignty, invaded the sovereignty of Chinese jurisdiction and should extend a formal apology in public as the requirement of the judgment.
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V. Even if the PE investors win suits or arbitrations, it is still impossible to take control of the invested corporations Facts and Reasons:
Valued occupations, such as legal representatives, directors of operation, chief financial officers and so on, are usually in the control of the previous legal representative, and so are important signatures and documents like official seals, data and bank accounts.
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Methods to Protect Lawful Interests of Foreign PE Investors in China
Part Five
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Applicable non-legal actions
Renew directors, supervisors and other senior executives of the domestic corporation through its inner procedure and complete the formalities of business change.
Take measures to control the important stuff, including official seals, the copy of business licenses of the corporation and the financial documents like accounting books.
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Civil Suits
Law suits of
I. the shareholders’ right to be informed
II. returning the official seals, financial accounting books
III. the damage of the directors, supervisors and senior executives
IV. the removal of obstacles
V. dismissing corporations
VI. representatives of shareholders
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Criminal Report
Report the defendant's alleged infringements to the police.
According to Criminal Law of the People’s Republic of
China, the former de facto controllers may be involved in the crime of diverting fund, duty encroachment, contract fraud, financial fraud, feigned capital contribution, capital flight and so on.
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